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8. PREFACE
There are many excellent text books on Banking written by well known British and American
writers. However, none of these can claim to cover the entire course of study prescribed by
the Indian Universities. Moreover, most of these books are above the understanding of an
average Indian student of Commerce and Economics. The present book is a humble effort
in this direction.
On account of the growing importance of the banking industry, most of the Indian
Universities have introduced a special paper on Banking for their degree students. The
present volume has been made to cover the syllabi of B.Com., B.B.M., M.B.A., M.Com., M.A.,
L.L.B., etc. In addition, I hope, it will also be of benefit to candidates appearing for various
competitive examinations such as I.A.S., I.E.S., C.A., N.E.T., and I.I.B. examinations. The
present volume contains 19 chapters devoted mainly to the study of Commercial Banks,
Central Bank, Reserve Bank of India, State Bank of India, Money and Capital Markets,
Indian Banking Systems, Banker and Customer Relationship, Operation of Bank Accounts,
Collection and Payment of Cheques, Loans and Advances, Types of Securities, Modes of
Creating Charge, Guarantee, Letter of Credit, Accounts and Audit of Banks. The last chapter
contains multiple choice and short-type questions for the benefit of the candidates who want
a deeper insight into Banking.
While preparing this book, I have collected the relevant material from government
publications, published and unpublished sources, books, journals and articles by eminent
scholars. My Principal, colleagues and friends have offered me valuable suggestions in the
preparation of the manuscript. My sincere thanks are due to all of them.
I have a great pleasure in expressing my profound gratitude to my revered Research Supervisor
Dr. S. Mahendra Kumar M.A., Ph.D., Department of Economics, Manasagangothri, Mysore,
who has contributed a lot for improving the quality of this volume. He has always been a source
of constant inspiration to me as a friend, philosopher and guide. I also express my deep sense
of gratitude to Dr. Gopal Singh, Co-ordinator, DOS in Economics, Govt. Arts College, Hassan,
Dr. K. A. Rajanna, Prof. H.K. Lalithadavi, Sri. Mahalinga (Sapna Book House); Bangalore, H.S.
Ravindra, Channarayapattna, Prof. K.T. Krishnegowda, R. Radhakrishna Hassan; Sudharshan,

9. viii Preface
Marketing Manager and Srinath, Branch Manager, New Age, Bangalore; Prof. T.N. Prabhakar,
Principal, Government Arts College, Hassan and my friends for rendering assistance in various
forms in preparing the manuscript of this book.
I also express my grateful thanks to New Age International Publishers, New Delhi for
bringing out this book in a record time. Thanks are also due to Madusudan, DATA LINK,
Bangalore for typing the manuscript with efficiency and patience.
Last, but not the least, I acknowledge with a sense of gratitude the services of my wife,
Smt. Sujatha Somashekar and my son, N.S. Swaroop, who not only left no stone unturned
in providing me a congenial atmosphere for studies at home, but also relieved me from a
number of family responsibilities and even more, at times, directly helped me in my work.
Any suggestion for enhancing the value of the book from students and teachers, would
be most welcome and would be kept in view at the time of bringing out the second edition.
With these words, I present this book to students, who alone will judge its worth.
Ne. Thi. Somashekar

10. CONTENTS
Preface vii
CHAPTER -1: COMMERCIAL BANKING 1-26
INTRODUCTION 1
Meaning 1
Definition of a Bank 1
TYPES OF BANKS 2
FUNCTIONS OF COMMERCIAL BANKS 4
SOURCES OF BANK’S INCOME 9
INVESTMENT POLICY OF BANKS 10
BALANCE SHEET OF THE BANK 12
Liabilities 12
Assets 14
CREDIT CREATION 15
Basis of Credit Creation 15
Process of Credit Creation 16
Leaf and Cannon Criticism 18
Limitation on Credit Creation 18
UNIT BANKING VS BRANCH BANKING 20
A. Unit Banking 20
B. Branch Banking System 22
COMMERCIAL BANKS AND ECONOMIC DEVELOPMENT 24
Conclusion 26
CHAPTER-2: CENTRAL BANKING 27-45
INTRODUCTION 27
Meaning of Central Bank 27
Definition of Central Bank 27
Functions of the Central Bank 28

11. x Contents
CREDIT CONTROL 31
Objectives of Credit Control 32
Methods of Credit Control 32
Meaning 33
Theory of Bank Rate 33
Working of Bank Rate 34
The Process of Bank Rate Influence 34
Bank Rate Under the Gold Standard 34
Conditions for the Success of the Bank Rate Policy 34
Limitations 35
Meaning 36
Theory of Open Market Operations 36
Objectives of Open Market Operations 37
Conditions for the Success of Open Market Operations 37
Popularity of Open Market Operations 38
A. Variable Cash Reserve Ratio 39
Meaning 39
B. Theory of Variable Reserve Ratio 39
Working of Variable Reserve Ratio 40
Limitations 41
Selective or Qualitative Methods 41
Objectives 42
Measures of Selective Credit Control 42
Conclusion 45
CHAPTER-3: RESERVE BANK OF INDIA 47-75
INTRODUCTION 47
Capital 48
Organisation 48
Offices of the Bank 49
Departments of the Reserve Bank 50
Functions of the Reserve Bank 51
CREDIT CONTROL 58
Weapons of Credit Control 58
METHODS OF SELECTIVE CREDIT CONTROLS ADOPTED BY RESERVE BANK 61
Limitations of Selective Controls in India 63
MONETARY POLICY OF THE RESERVE BANK OF INDIA 64
Reserve Bank of India and Monetary Controls 64
Limitations of Monetary Policy 66
Chakravarthy Report on the Working of the Monetary System 67
The Narasimham Committee Report (1991) 68
Recommendations of the Committee 68
The Goiporia Committee Report (1991) 70
Recommendations of Goiporia Committee 70
The Narasimham Committee Report (1998) 71

12. Contents xi
ROLE OF RBI IN ECONOMIC DEVELOPMENT 71
Contribution to Economic Development 72
Conclusion 75
CHAPTER-4: STATE BANK OF INDIA 77-81
INTRODUCTION 77
Capital 77
Management 77
Functions 78
Role of the State Bank in Economic Development 79
Conclusion 80
CHAPTER-5: MONEY MARKET AND CAPITAL MARKET 83-105
INTRODUCTION 83
Money Market 83
Functions of Money Market 83
Composition of the Money Market 84
Financial Institutions of the Money Market 85
Characteristics of a Developed Money Market 86
Usefulness of a Developed Money Market 87
Structure of the Money Market 88
Characteristics of Indian Money Market 89
Defects of Indian Money Market 89
Measures for Improvement of the Money Market 91
Suggestions to Remove Defects in the Indian Money Market 93
The Repo Market 95
The Commercial Bill Market 96
The Certificate of Deposit (CD) Market 97
The Commercial Paper Market 98
Money Market Mutual Funds 98
Capital Market 99
Classification of Indian Capital Market 99
Importance of Capital Market 100
Functions of Capital Market 100
Structure of Indian Capital Market 101
Components of Indian Capital Market 101
Recent Trends in the Capital Market 102
Comparison of Money Market and Capital Market 104
Conclusion 105
CHAPTER-6: STRUCTURE OF BANKING IN INDIA 107-137
INTRODUCTION 107
1. INDIGENOUS BANKS 107
Meaning 109
Groups 109
Types 109

13. xii Contents
Functions of Indigenous Bankers 109
Defects of Indigenous Bankers 110
Indigenous Bankers and the Reserve Bank 111
Suggestions for Reform 111
2. MONEYLENDERS 112
Features of Moneylenders 112
Differences Between Moneylenders and Indigenous Bankers 112
Defects of Moneylenders 113
3. CO-OPERATIVE BANKS 113
Meaning 114
Structure of Co-operative Banks 114
Progress of PACS 115
Shortfalls PACS 116
Functions 116
Progress of CCBs 117
Defects of CCBs 117
Functions 118
Defects 118
Progress 118
Present Position of Co-operative Banks 118
Importance or Benefits of Co-operative Banks 119
Problems or Weaknesses of Co-operative Banks 119
Suggestions for the Improvement of the Co-operative Credit Structure 120
4. LAND DEVELOPMENT BANK 121
Sources of Funds 122
The Working of the LDBs 122
Progress 122
Defects 122
Suggestions for Improvement 123
5. REGIONAL RURAL BANKS 123
Objectives of Regional Rural Banks 123
Capital Structure 124
Features of Regional Rural Banks 124
Functions of Regional Rural Banks 124
Progress Achieved by Regional Rural Banks 124
Problems 125
Suggestions for Reorganisation and Improvement 127
6. NABARD 128
Objectives 128
NABARD’s Financial Resources 128
Management 128
Functions of NABARD 129
Achievements of NABARD 130
7. COMMERCIAL BANKS 132
Nationalisation of Banks 132
Achievements of Nationalised Banks 132

14. Contents xiii
8. CREDIT CARDS 136
Advantages of Credit Cards 136
Limitations or Drawbacks of Credit Cards 136
Conclusion 136
CHAPTER-7: DEVELOPMENT BANKS 139-158
INTRODUCTION 139
Meaning 139
Features 139
Important Development Banks in India 140
1. INDUSTRIAL FINANCE CORPORATION OF INDIA LTD. 140
Functions of the IFCI 141
Financial Resources of IFCI 141
Lending Operations of IFCI 142
Appraisal of IFCI’s Performance 142
2. THE INDUSTRIAL CREDIT AND INVESTMENT CORPORATION OF INDIA LTD. 143
Financial Resources of ICICI 143
Lending Operations of ICICI 143
Appraisal of ICICI’s Performance 144
3. STATE FINANCIAL CORPORATIONS 145
4. THE INDUSTRIAL DEVELOPMENT BANK OF INDIA 148
Financial Resources of IDBI 148
Cumulative Assistance by IDBI 148
Composition of Financial Assistance 149
Promotional Functions of the IDBI 150
Critical Appraisal 150
5. SMALL INDUSTRIES DEVELOPMENT BANK OF INDIA 151
Financial Resources of SIDBI 151
Financial Assistance by SIDBI 151
6. THE INDUSTRIAL RECONSTRUCTION BANK OF INDIA (IRBI) 151
7. THE STATE INDUSTRIAL DEVELOPMENT CORPORATIONS (SIDCS) AND THE STATE 151
INDUSTRIAL INVESTMENT CORPORATIONS (SIICS) 152
8. UNIT TRUST OF INDIA 153
Present Position 153
9. LIFE INSURANCE CORPORATION OF INDIA (LIC) 154
Present Position 155
10. THE EXPORT-IMPORT BANK OF INDIA (EXIM BANK) 156
Functions of the EXIM Bank 156
Present Position 156
Conclusion 157
CHAPTER-8: BANKER AND CUSTOMER 159-184
INTRODUCTION 159
Meaning and Definition of a Banker 159

15. xiv Contents
Meaning and Definition of a Customer 161
Special Types of Customers 163
Legal Provisions Regarding Guardianship of a Minor 164
The Banker-Customer Relationship 171
A. General relationship, and B. Special relationship 171
1. Primary relationship 171
2. Secondary relationship 172
Obligations of Bankers 179
1. Obligation to Honour the Customer’s Cheques 179
2. Obligation to Maintain Secrecy of Customer’s Account 181
3. Obligation to Receive Cheques and Other Instruments for Collection 182
4. Obligation to Give Reasonable Notice before Closing the Account 182
Obligations of Customers 183
Conclusion 183
CHAPTER-9: OPENING AND OPERATING BANK ACCOUNTS 185-196
INTRODUCTION 185
Types of Accounts 185
Procedure of Opening Current and Savings Accounts 189
Forms Used in Operation of Bank Account 191
Closing of a Bank Account 192
Insurance of Bank Deposit 193
Deposit Insurance and Credit Guarantee Corporation (DICGC) 193
Objectives 193
Credit Guarantee Function 193
Nomination Facility 194
Non-Resident Account 195
Recent Development 195
Conclusion 196
CHAPTER-10: PASS BOOK 197-202
INTRODUCTION 197
Meaning of Pass Book 197
Object or Purpose of Pass Book 198
Statement of Account 198
Examination of Entries 198
Legal Position of Entries in the Pass Book 199
Effect of Entries in the Pass Book 199
Precautions in Writing a Pass Book 201
Conclusion 202
CHAPTER-11: CHEQUES 203-220
INTRODUCTION 203
Meaning 203

16. Contents xv
Definition 204
Essentials 204
Types of Cheques 205
Uses of a Cheque 206
Advantages of Using Printed Forms 206
Parties to a Cheque 207
MATERIAL ALTERATIONS 207
Alteration 207
Material Alteration 207
Examples of Material Alterations 207
Examples of Authorised Alterations 208
Examples of Non-material Alterations 208
Effects of Material Alteration 208
CROSSING OF CHEQUES 209
Meaning of Crossing 209
Types of Crossing 209
Special Crossing 210
Other Types of Crossing 211
Significance of Crossing 212
ENDORSEMENT 213
Definition of Endorsement 213
Essentials of a Valid Endorsement 213
Kinds of Endorsement 214
Legal Effects of an Endorsement 215
Differences Between a Bill of Exchange and Cheque 215
Distinguish Between a Cheque and a Promissory Note 216
HOLDER AND HOLDER IN DUE COURSE 217
Holder 217
Holder in Due Course 217
Privileges of a Holder in Due Course 218
Distinction Between Holder and Holder in Due Course 219
Conclusion 220
CHAPTER-12: THE PAYING BANKER 221-229
INTRODUCTION 221
Meaning 221
Precautions for Payment of Cheques 222
Precautions 222
Statutory Protection 225
Protection Available Under the Negotiable Instruments Act 225
Dishonour of Cheques 227
When a Banker can Dishonour Cheques 228
Bank’s Remarks on Dishonoured Cheques 229
Conclusion 229

17. xvi Contents
CHAPTER-13: COLLECTING BANKER 231-238
INTRODUCTION 231
Meaning 231
Collecting Banker as Holder for Value 231
Collecting Banker as an Agent of the Customer 232
Conversion 233
Statutory Protection to Collecting Banker 233
Duties and Responsibilities of a Collecting Banker 235
Marking of Cheque 236
Who Can Get the Cheque Marked? 236
Conclusion 237
CHAPTER-14: LOANS AND ADVANCES 239-247
INTRODUCTION 239
General Rules of Sound Lending 239
Forms of Lending (Advances) 241
Merits of Granting Loans 242
Demerits 242
Merits of Cash Credit 243
Demerits 243
Distinction Between Loan and Cash Credit 244
Distinction Between Cash Credit and Overdraft 244
Types of Loans and Advances 245
Determining Creditworthiness 246
Sources of Credit Information 246
Conclusion 247
CHAPTER-15: TYPES OF SECURITIES 249-268
INTRODUCTION 249
Characteristics of Good Security 249
General Principles of Secured Advances 250
Types of Securities on which Loans or Advances can be Granted 251
Precautions 257
Merits of Advances Against Stock Exchange Securities 258
Risks in Advancing Against Securities 259
Precautions to be Taken in Advancing Against Securities 259
Precautions in Advancing Against Real Estate 262
Merits of Life Insurance Policy as a Security 264
Demerits of Policies as Securities 264
Precautions in Advancing Against LIC Policies 265
Precautions in Advancing Against Fixed Deposit Receipt 266
Precautions in Advancing Against Book Debts 267
Conclusion 268

18. Contents xvii
CHAPTER-16: MODES OF CREATING CHARGE 269-280
INTRODUCTION 269
Modes of Creating Charge 269
Difference Between Pledge and Lien 270
Who can Pledge the Goods? 271
Right and Obligations of Pledger 272
Rights 272
Obligations (Duties) 272
Right and Obligations of Pledgee or Pawnee 272
Obligation and Duties of Pledgee 273
Essential Features of a Mortgage 273
Types of Mortgages 274
Legal and Equitable Mortgage 276
Merits of Equitable Mortgage over the Legal Mortgage 276
Demerits of Equitable Mortgage over the Legal Mortgage 276
Rights of Mortgager 277
Rights of Mortgagee (Banker) 277
Precautions to be Taken by a Banker in Case of Lending Against Hypothecation 278
Conclusion 279
CHAPTER-17: GUARANTEES 281-291
INTRODUCTION 281
Meaning 281
Definition 281
Necessity for Bank Guarantee 282
Essentials of a Valid Guarantee 282
Kinds of Guarantees 283
Contract of Guarantee 285
Purpose of the Contract 286
Contract of Indemnity 286
Parties to Indemnity 286
Analysis of the Definition 286
Difference between Contract of Guarantee and a Contract of Indemnity 287
Rights of the Surety 287
Liability of the Surety 288
Rights of the Banker 288
Liabilities of the Banker (Obligation) 288
Merits and Demerits of Guarantee 289
Merits of Guarantee 289
Demerits of Guarantee 289
Precautions to be Taken by the Banker in a Contract of Guarantee 290
Conclusion 291

19. xviii Contents
CHAPTER-18: LETTER OF CREDIT 293-300
INTRODUCTION 293
Definition 293
Types of Letters of Credit 294
I. Travellers’ Letter of Credit 295
II. Commercial Letter of Credit 296
Types of Letters of Commercial Credit 296
Opening a Letter of Credit 298
ADVANTAGES OF LETTER OF CREDIT 299
Advantages to the Exporter 299
Advantages to the Importer 299
Conclusion 300
CHAPTER-19: ACCOUNTS AND AUDIT OF BANKS 301-309
INTRODUCTION 301
Salient Features of Bank’s Accounts 301
Books of Account (Section 209) 302
Books shall Give a True and Fair View 302
Preservation of Books 302
Persons Responsible to Keep the Books 302
Penalty 302
Inspection of Books of Account 303
Books to be Maintained 303
Final Accounts 306
Preparation of Balance Sheet and Profit and Loss Account (Sec. 47) 306
Form of Balance Sheet and Profit and Loss Account 306
Signing of Balance Sheet and Profit and Loss Account 306
Audit of Bank Accounts 306
Audit of Accounts (Section 30) 306
Publication and Filing of Accounts (Section 30) 307
Penalty 309
Conclusion 309
MULTIPLE CHOICE QUESTIONS WITH ANSWERS 311-358

20. 1
COMMERCIAL BANKING
INTRODUCTION
Banking occupies one of the most important positions in the modern economic world.
It is necessary for trade and industry. Hence it is one of the great agencies of commerce.
Although banking in one form or another has been in existence from very early times,
modern banking is of recent origin. It is one of the results of the Industrial Revolution and
the child of economic necessity. Its presence is very helpful to the economic activity and
industrial progress of a country.
Meaning
A commercial bank is a profit-seeking business firm, dealing in money and credit. It is a
financial institution dealing in money in the sense that it accepts deposits of money from the
public to keep them in its custody for safety. So also, it deals in credit, i.e., it creates credit by
making advances out of the funds received as deposits to needy people. It thus, functions as a
mobiliser of saving in the economy. A bank is, therefore like a reservoir into which flow the
savings, the idle surplus money of households and from which loans are given on interest to
businessmen and others who need them for investment or productive uses.
Definition of a Bank
The term ‘Bank’ has been defined in different ways by different economists. A few definitions
are:
According to Walter Leaf “A bank is a person or corporation which holds itself out to
receive from the public, deposits payable on demand by cheque.” Horace White has defined
a bank, “as a manufacture of credit and a machine for facilitating exchange.”
According to Prof. Kinley, “A bank is an establishment which makes to individuals such
advances of money as may be required and safely made, and to which individuals entrust
money when not required by them for use.”

21. 2 Banking
The Banking Companies Act of India defines Bank as “A Bank is a financial institution
which accepts money from the public for the purpose of lending or investment repayable on
demand or otherwise withdrawable by cheques, drafts or order or otherwise.”
Thus, we can say that a bank is a financial institution which deals in debts and credits.
It accepts deposits, lends money and also creates money. It bridges the gap between the
savers and borrowers. Banks are not merely traders in money but also in an important sense
manufacturers of money.
TYPES OF BANKS
Broadly speaking, banks can be classified into commercial banks and central bank.
Commercial banks are those which provide banking services for profit. The central bank has
the function of controlling commercial banks and various other economic activities. There
are many types of commercial banks such as deposit banks, industrial banks, savings banks,
agricultural banks, exchange banks, and miscellaneous banks.
Types of Commercial Banks
1. Deposit Banks: The most important type of deposit banks is the commercial banks.
They have connection with the commercial class of people. These banks accept
deposits from the public and lend them to needy parties. Since their deposits are
for short period only, these banks extend loans only for a short period. Ordinarily
these banks lend money for a period between 3 to 6 months. They do not like to lend
money for long periods or to invest their funds in any way in long term securities.
2. Industrial Banks: Industries require a huge capital for a long period to buy machinery
and equipment. Industrial banks help such industrialists. They provide long term loans
to industries. Besides, they buy shares and debentures of companies, and enable them
to have fixed capital. Sometimes, they even underwrite the debentures and shares of big
industrial concerns. The important functions of industrial banks are:

22. Commercial Banking 3
1. They accept long term deposits.
2. They meet the credit requirements of industries by extending long term loans.
3. These banks advise the industrial firms regarding the sale and purchase of shares
and debentures.
The industrial banks play a vital role in accelerating industrial development. In
India, after attainment of independence, several industrial banks were started with
large paid up capital. They are, The Industrial Finance Corporation (I.F.C.), The
State Financial Corporations (S.F.C.), Industrial Credit and Investment Corporation
of India (ICICI) and Industrial Development Bank of India (IDBI) etc.
3. Savings Banks: These banks were specially established to encourage thrift among
small savers and therefore, they were willing to accept small sums as deposits. They
encourage savings of the poor and middle class people. In India we do not have such
special institutions, but post offices perform such functions. After nationalisation
most of the nationalised banks accept the saving deposits.
4. Agricultural Banks: Agriculture has its own problems and hence there are separate
banks to finance it. These banks are organised on co-operative lines and therefore
do not work on the principle of maximum profit for the shareholders. These banks
meet the credit requirements of the farmers through term loans, viz., short, medium
and long term loans. There are two types of agricultural banks,
(a) Agricultural Co-operative Banks, and
(b) Land Mortgage Banks. Co-operative Banks are mainly for short periods. For long
periods there are Land Mortgage Banks. Both these types of banks are performing
useful functions in India.
5. Exchange Banks: These banks finance mostly for the foreign trade of a country.
Their main function is to discount, accept and collect foreign bills of exchange. They
buy and sell foreign currency and thus help businessmen in their transactions. They
also carry on the ordinary banking business.
In India, there are some commercial banks which are branches of foreign banks.
These banks facilitate for the conversion of Indian currency into foreign currency
to make payments to foreign exporters. They purchase bills from exporters and sell
their proceeds to importers. They purchase and sell “forward exchange” too and
thus minimise the difference in exchange rates between different periods, and also
protect merchants from losses arising out of exchange fluctuations by bearing the
risk. The industrial and commercial development of a country depends these days,
largely upon the efficiency of these institutions.
6. Miscellaneous Banks: There are certain kinds of banks which have arisen in due
course to meet the specialised needs of the people. In England and America, there are
investment banks whose object is to control the distribution of capital into several uses.
American Trade Unions have got labour banks, where the savings of the labourers are
pooled together. In London, there are the London Discount House whose business is “to
go about the city seeking for bills to discount.” There are numerous types of different
banks in the world, carrying on one or the other banking business.

23. 4 Banking
FUNCTIONS OF COMMERCIAL BANKS
Commercial banks have to perform a variety of functions which are common to both
developed and developing countries. These are known as ‘General Banking’ functions of the
commercial banks. The modern banks perform a variety of functions. These can be broadly
divided into two categories: (a) Primary functions and (b) Secondary functions.
A. Primary Functions
Primary banking functions of the commercial banks include:
1. Acceptance of deposits
2. Advancing loans
3. Creation of credit
4. Clearing of cheques
5. Financing foreign trade
6. Remittance of funds
1. Acceptance of Deposits: Accepting deposits is the primary function of a commercial
bank mobilise savings of the household sector. Banks generally accept three types of
deposits viz., (a) Current Deposits (b) Savings Deposits, and (c) Fixed Deposits.
(a) Current Deposits: These deposits are also known as demand deposits. These
deposits can be withdrawn at any time. Generally, no interest is allowed on
current deposits, and in case, the customer is required to leave a minimum
balance undrawn with the bank. Cheques are used to withdraw the amount.
These deposits are kept by businessmen and industrialists who receive and make

24. Commercial Banking 5
large payments through banks. The bank levies certain incidental charges on the
customer for the services rendered by it.
(b) Savings Deposits: This is meant mainly for professional men and middle class
people to help them deposit their small savings. It can be opened without any
introduction. Money can be deposited at any time but the maximum cannot go
beyond a certain limit. There is a restriction on the amount that can be withdrawn
at a particular time or during a week. If the customer wishes to withdraw more
than the specified amount at any one time, he has to give prior notice. Interest is
allowed on the credit balance of this account. The rate of interest is greater than
the rate of interest on the current deposits and less than that on fixed deposit.
This system greatly encourages the habit of thrift or savings.
(c) Fixed Deposits: These deposits are also known as time deposits. These deposits
cannot be withdrawn before the expiry of the period for which they are deposited
or without giving a prior notice for withdrawal. If the depositor is in need of
money, he has to borrow on the security of this account and pay a slightly higher
rate of interest to the bank. They are attracted by the payment of interest which
is usually higher for longer period. Fixed deposits are liked by depositors both for
their safety and as well as for their interest. In India, they are accepted between
three months and ten years.
2. Advancing Loans: The second primary function of a commercial bank is to
make loans and advances to all types of persons, particularly to businessmen and
entrepreneurs. Loans are made against personal security, gold and silver, stocks of
goods and other assets. The most common way of lending is by:
(a) Overdraft Facilities: In this case, the depositor in a current account is allowed to draw
over and above his account up to a previously agreed limit. Suppose a businessman
has only Rs. 30,000/- in his current account in a bank but requires Rs. 60,000/- to
meet his expenses. He may approach his bank and borrow the additional amount
of Rs. 30,000/-. The bank allows the customer to overdraw his account through
cheques. The bank, however, charges interest only on the amount overdrawn from
the account. This type of loan is very popular with the Indian businessmen.
(b) Cash Credit: Under this account, the bank gives loans to the borrowers against
certain security. But the entire loan is not given at one particular time, instead the
amount is credited into his account in the bank; but under emergency cash will
be given. The borrower is required to pay interest only on the amount of credit
availed to him. He will be allowed to withdraw small sums of money according to
his requirements through cheques, but he cannot exceed the credit limit allowed
to him. Besides, the bank can also give specified loan to a person, for a firm
against some collateral security. The bank can recall such loans at its option.
(c) Discounting Bills of Exchange: This is another type of lending which is very
popular with the modern banks. The holder of a bill can get it discounted by the
bank, when he is in need of money. After deducting its commission, the bank

25. 6 Banking
pays the present price of the bill to the holder. Such bills form good investment
for a bank. They provide a very liquid asset which can be quickly turned into
cash. The commercial banks can rediscount, the discounted bills with the central
banks when they are in need of money. These bills are safe and secured bills.
When the bill matures the bank can secure its payment from the party which had
accepted the bill.
(d) Money at Call: Bank also grant loans for a very short period, generally not
exceeding 7 days to the borrowers, usually dealers or brokers in stock exchange
markets against collateral securities like stock or equity shares, debentures, etc.,
offered by them. Such advances are repayable immediately at short notice hence,
they are described as money at call or call money.
(e) Term Loans: Banks give term loans to traders, industrialists and now to agriculturists
also against some collateral securities. Term loans are so-called because their maturity
period varies between 1 to 10 years. Term loans, as such provide intermediate or
working capital funds to the borrowers. Sometimes, two or more banks may jointly
provide large term loans to the borrower against a common security. Such loans are
called participation loans or consortium finance.
(f) Consumer Credit: Banks also grant credit to households in a limited amount to
buy some durable consumer goods such as television sets, refrigerators, etc., or
to meet some personal needs like payment of hospital bills etc. Such consumer
credit is made in a lump sum and is repayable in instalments in a short time. Un-
der the 20-point programme, the scope of consumer credit has been extended to
cover expenses on marriage, funeral etc., as well.
(g) Miscellaneous Advances: Among other forms of bank advances there are packing
credits given to exporters for a short duration, export bills purchased/discounted,
import finance-advances against import bills, finance to the self employed, credit
to the public sector, credit to the cooperative sector and above all, credit to the
weaker sections of the community at concessional rates.
3. Creation of Credit: A unique function of the bank is to create credit. Banks supply
money to traders and manufacturers. They also create or manufacture money. Bank
deposits are regarded as money. They are as good as cash. The reason is they can be
used for the purchase of goods and services and also in payment of debts. When a
bank grants a loan to its customer, it does not pay cash. It simply credits the account
of the borrower. He can withdraw the amount whenever he wants by a cheque. In
this case, bank has created a deposit without receiving cash. That is, banks are said
to have created credit. Sayers says “banks are not merely purveyors of money, but
also in an important sense, manufacturers of money.”
4. Promote the Use of Cheques: The commercial banks render an important service by
providing to their customers a cheap medium of exchange like cheques. It is found much
more convenient to settle debts through cheques rather than through the use of cash.
The cheque is the most developed type of credit instrument in the money market.

26. Commercial Banking 7
5. Financing Internal and Foreign Trade: The bank finances internal and foreign
trade through discounting of exchange bills. Sometimes, the bank gives short-term
loans to traders on the security of commercial papers. This discounting business
greatly facilitates the movement of internal and external trade.
6. Remittance of Funds: Commercial banks, on account of their network of branches
throughout the country, also provide facilities to remit funds from one place to another
for their customers by issuing bank drafts, mail transfers or telegraphic transfers
on nominal commission charges. As compared to the postal money orders or other
instruments, bank drafts have proved to be a much cheaper mode of transferring
money and has helped the business community considerably.
B. Secondary Functions
Secondary banking functions of the commercial banks include:
1. Agency Services
2. General Utility Services
These are discussed below.
1. Agency Services: Banks also perform certain agency functions for and on behalf
of their customers. The agency services are of immense value to the people at large.
The various agency services rendered by banks are as follows:
(a) Collection and Payment of Credit Instruments: Banks collect and pay various credit
instruments like cheques, bills of exchange, promissory notes etc., on behalf of
their customers.
(b) Purchase and Sale of Securities: Banks purchase and sell various securities like
shares, stocks, bonds, debentures on behalf of their customers.
(c) Collection of Dividends on Shares: Banks collect dividends and interest on shares
and debentures of their customers and credit them to their accounts.
(d) Acts as Correspondent: Sometimes banks act as representative and correspondents
of their customers. They get passports, traveller’s tickets and even secure air and
sea passages for their customers.
(e) Income-tax Consultancy: Banks may also employ income tax experts to prepare
income tax returns for their customers and to help them to get refund of income
tax.
(f) Execution of Standing Orders: Banks execute the standing instructions of their
customers for making various periodic payments. They pay subscriptions, rents,
insurance premia etc., on behalf of their customers.
(g) Acts as Trustee and Executor: Banks preserve the ‘Wills’ of their customers and
execute them after their death.
2. General Utility Services: In addition to agency services, the modern banks provide
many general utility services for the community as given.

27. 8 Banking
(a) Locker Facility: Bank provide locker facility to their customers. The customers can
keep their valuables, such as gold and silver ornaments, important documents;
shares and debentures in these lockers for safe custody.
(b) Traveller’s Cheques and Credit Cards: Banks issue traveller’s cheques to help their
customers to travel without the fear of theft or loss of money. With this facility,
the customers need not take the risk of carrying cash with them during their
travels.
(c) Letter of Credit: Letters of credit are issued by the banks to their customers
certifying their credit worthiness. Letters of credit are very useful in foreign
trade.
(d) Collection of Statistics: Banks collect statistics giving important information relating
to trade, commerce, industries, money and banking. They also publish valuable
journals and bulletins containing articles on economic and financial matters.
(e) Acting Referee: Banks may act as referees with respect to the financial standing,
business reputation and respectability of customers.
(f) Underwriting Securities: Banks underwrite the shares and debentures issued by
the Government, public or private companies.
(g) Gift Cheques: Some banks issue cheques of various denominations to be used on
auspicious occasions.
(h) Accepting Bills of Exchange on Behalf of Customers: Sometimes, banks accept bills
of exchange, internal as well as foreign, on behalf of their customers. It enables
customers to import goods.
(i) Merchant Banking: Some commercial banks have opened merchant banking
divisions to provide merchant banking services.
C. Fulfillment of Socio-Economic Objectives
In recent years, commercial banks, particularly in developing countries, have been called
upon to help achieve certain socio-economic objectives laid down by the state. For example,
the nationalized banks in India have framed special innovative schemes of credit to help
small agriculturists, village and cottage industries, retailers, artisans, the self employed
persons through loans and advances at concessional rates of interest. Under the Differential
Interest Scheme (D.I.S.) the nationalized banks in India advance loans to persons belonging
to scheduled tribes, tailors, rickshaw-walas, shoe-makers at the concessional rate of 4 per cent
per annum. This does not cover even the cost of the funds made available to these priority
sectors. Banking is, thus, being used to subserve the national policy objectives of reducing
inequalities of income and wealth, removal of poverty and elimination of unemployment in
the country.
It is clear from the above that banks help development of trade and industry in the country.
They encourage habits of thrift and saving. They help capital formation in the country. They
lend money to traders and manufacturers. In the modern world, banks are to be considered
not merely as dealers in money but also the leaders in economic development.

28. Commercial Banking 9
SOURCES OF BANK’S INCOME
A bank is a business organisation engaged in the business of borrowing and lending money.
A bank can earn income only if it borrows at a lower rate and lends at a higher rate. The
difference between the two rates will represent the costs incurred by the bank and the profit.
Bank also provides a number of services to its customers for which it charges commission.
This is also an important source of income. The followings are the various sources of a
bank’s profit:
1. Interest on Loans: The main function of a commercial bank is to borrow money for
the purpose of lending at a higher rate of interest. Bank grants various types of loans to
the industrialists and traders. The yields from loans constitute the major portion of the
income of a bank. The banks grant loans generally for short periods. But now the banks
also advance call loans which can be called at a very short notice. Such loans are granted
to share brokers and other banks. These assets are highly liquid because they can be
called at any time. Moreover, they are source of income to the bank.
2. Interest on Investments: Banks also invest an important portion of their resources
in government and other first class industrial securities. The interest and dividend
received from time to time on these investments is a source of income for the banks.
Bank also earn some income when the market prices of these securities rise.
3. Discounts: Commercial banks invest a part of their funds in bills of exchange by
discounting them. Banks discount both foreign and inland bills of exchange, or in
other words, they purchase the bills at discount and receive the full amount at the
date of maturity. For instance, if a bill of Rs. 1000 is discounted for Rs. 975, the
bank earns a discount of Rs. 25 because bank pays Rs. 975 today, but will get Rs.
1000 on the due date. Discount, as a matter of fact, is the interest on the amount
paid for the remaining period of the bill. The rate of discount on bills of exchange is
slightly lower than the interest rate charged on loans and advances because bills are
considered to be highly liquid assets.
4. Commission, Brokerage, etc.: Banks perform numerous services to their
customers and charge commission, etc., for such services. Banks collect cheques,
rents, dividends, etc., accepts bills of exchange, issue drafts and letters of credit
and collect pensions and salaries on behalf of their customers. They pay insurance
premiums, rents, taxes etc., on behalf of their customers. For all these services banks
charge their commission. They also earn locker rents for providing safety vaults to
their customers. Recently the banks have also started underwriting the shares and
debentures issued by the joint stock companies for which they receive underwriting
commission.
Commercial banks also deal in foreign exchange. They sell demand drafts, issue letters of
credit and help remittance of funds in foreign countries. They also act as brokers in foreign
exchange. Banks earn income out of these operations.

29. 10 Banking
INVESTMENT POLICY OF BANKS
The financial position of a commercial bank is reflected in its balance sheet. The balance
sheet is a statement of the assets and liabilities of the bank. The assets of the bank are
distributed in accordance with certain guiding principles. These principles underline the
investment policy of the bank. They are discussed below:
1. Liquidity: In the context of the balance sheet of a bank the term liquidity has two
interpretations. First, it refers to the ability of the bank to honour the claims of the
depositors. Second, it connotes the ability of the bank to convert its non-cash assets
into cash easily and without loss.
It is a well known fact that a bank deals in funds belonging to the public. Hence,
the bank should always be on its guard in handling these funds. The bank should
always have enough cash to meet the demands of the depositors. In fact, the success
of a bank depends to a considerable extent upon the degree of confidence it can instill
in the minds of its depositors. If the depositors lose confidence in the integrity of
their bank, the very existence of the bank will be at stake. So, the bank should always
be prepared to meet the claims of the depositors by having enough cash. Among the
various items on the assets side of the balance sheet, cash on hand represents the
most liquid asset. Next comes cash with other banks and the central bank. The order
of liquidity goes on descending.
Liquidity also means the ability of the bank to convert its non-cash assets into
cash easily and without loss. The bank cannot have all its assets in the form of cash
because each is an idle asset which does not fetch any return to the bank. So some of
the assets of the bank, money at call and short notice, bills discounted, etc. could be
made liquid easily and without loss.
2. Profitability: A commercial bank by definition, is a profit hunting institution. The
bank has to earn profit to earn income to pay salaries to the staff, interest to the
depositors, dividend to the shareholders and to meet the day-to-day expenditure.
Since cash is the least profitable asset to the bank, there is no point in keeping all the
assets in the form of cash on hand. The bank has got to earn income. Hence, some
of the items on the assets side are profit yielding assets. They include money at call
and short notice, bills discounted, investments, loans and advances, etc. Loans and
advances, though the least liquid asset, constitute the most profitable asset to the
bank. Much of the income of the bank accrues by way of interest charged on loans
and advances. But, the bank has to be highly discreet while advancing loans.
3. Safety or Security: Apart from liquidity and profitability, the bank should look
to the principle of safety of its funds also for its smooth working. While advancing
loans, it is necessary that the bank should consider the three ‘C’ s of credit character,
capacity and the collateral of the borrower. The bank cannot afford to invest its funds
recklessly without considering the principle of safety. The loans and investments
made by the bank should be adequately secured. For this purpose, the bank should

30. Commercial Banking 11
always insist on security of the borrower. Of late, somehow or other the banks have
not been paying adequate importance to safety, particularly in India.
4. Diversity: The bank should invest its funds in such a way as to secure for itself
an adequate and permanent return. And while investing its funds, the bank should
not keep all its eggs in the same basket. Diversification of investment is necessary
to avoid the dangerous consequences of investing in one or two channels. If the
bank invest its funds in different types of securities or makes loans and advances
to different objectives and enterprises, it shall ensure for itself a regular flow of
income.
5. Saleability of Securities: Further, the bank should invest its funds in such types
of securities as can be easily marketed at a time of emergency. The bank cannot
afford to invest its funds in very long term securities or those securities which are
unsaleable. It is necessary for the bank to invest its funds in government or in first
class securities or in debentures of reputed firms. It should also advance loans against
stocks which can be easily sold.
6. Stability in the Value of Investments: The bank should invest its funds in those
stocks and securities the prices of which are more or less stable. The bank cannot
afford to invest its funds in securities, the prices of which are subject to frequent
fluctuations.
7. Principles of Tax-Exemption of Investments: Finally, the investment policy of
a bank should be based on the principle of tax exemption of investments. The bank
should invest in those government securities which are exempted from income and
other taxes. This will help the bank to increase its profits.
Of late, there has been a controversy regarding the relative importance of the
various principles influencing the investment policy of a bank particularly between
liquidity and profitability. It is interesting to examine this controversy.
Let us examine what happens if the bank sticks to the principle of liquidity only. It is
true that if the bank pays importance to liquidity, it can easily meet the demands of the
depositors. The bank should have adequate cash to meet the claims of the depositors. It
is true that a successful banking business calls for installing confidence in the minds of
the depositors. But, it should be noted that accepting deposits is not the only function of
a bank. Moreover, the bank cannot afford to forget the fact that it has to earn income to
pay salaries to the staff, interest to the depositors, dividend to the shareholders and meet
the day-to-day expenditure. If the bank keeps all its resources in liquid form, it will not
be able to earn even a rupee. But profitability is a must for the bank. Though cash on
hand is the most liquid asset, it is the least profitable asset as well. Cash is an idle asset.
Hence, the banker cannot concentrate on liquidity only.
If the bank attaches importance to profitability only, it would be equally
disastrous to the very survival of a bank. It is true that a bank needs income to
meet its expenditure and pay returns to the depositors and shareholders. The bank
cannot undermine the interests of the depositors. If the bank lends out all its funds,

31. 12 Banking
it will be left with no cash at all to meet the claims of the depositors. It should be
noted that the bank should have cash to honour the obligations of the depositors.
Otherwise, there will be a ‘run’ on the bank. A run on the bank would be suicidal to
the very existence of the bank. Loans and advances, though the most profitable asset,
constitute the least liquid asset.
It follows from the above that the choice is between liquidity and profitability.
The constant tug of war between liquidity and profitability is the feature of the assets
side. According to Crowther, liquidity and profitability are opposing or conflicting
considerations. The secret of successful banking lies in striking a balance between
the two.
BALANCE SHEET OF THE BANK
The balance sheet of a commercial bank is a statement of its assets and liabilities. Assets
are what others owe the bank, and what the bank owes others constitutes its liabilities. The
business of a bank is reflected in its balance sheet and hence its financial position as well.
The balance sheet is issued usually at the end of every financial year of the bank.
The balance sheet of the bank comprises of two sides; the assets side and the liabilities
side. It is customary to record liabilities on the left side and assets on the right side. The
following is the proforma of a balance sheet of the bank.
Balance Sheet of the Bank
Liabilities Assets
1. Capital 1. Cash
a. Authorised capital a. Cash on hand
b. Issued capital b. Cash with central bank and other banks
c. Subscribed capital
d. Paid-up-capital
2. Reserve fund 2. Money at call and short notice
3. Deposits 3. Bills discounted
4. Borrowings from other banks 4. Bills for collection
5. Bills payable 5. Investments
6. Acceptances and endorsements 6. Loans and advances
7. Contingent liabilities 7. Acceptances and endorsement
8. Profit and loss account 8. Fixed assets
9. Bills for collection
Liabilities
Liabilities are those items on account of which the bank is liable to pay others. They
denote other’s claims on the bank. Now we have to analyse the various items on the
liabilities side.

32. Commercial Banking 13
1. Capital: The bank has to raise capital before commencing its business. Authorised
capital is the maximum capital upto which the bank is empowered to raise capital by
the Memorandum of Association. Generally, the entire authorised capital is not raised
from the public. That part of authorised capital which is issued in the form of shares
for public subscription is called the issued capital. Subscribed capital represents that
part of issued capital which is actually subscribed by the public. Finally, paid-up
capital is that part of the subscribed capital which the subscribers are actually called
upon to pay.
2. Reserve Fund: Reserve fund is the accumulated undistributed profits of the bank.
The bank maintains reserve fund to tide over any crisis. But, it belongs to the
shareholders and hence a liability on the bank. In India, the commercial bank is
required by law to transfer 20 per cent of its annual profits to the Reserve fund.
3. Deposits: The deposits of the public like demand deposits, savings deposits and
fixed deposits constitute an important item on the liabilities side of the balance sheet.
The success of any banking business depends to a large extent upon the degree of
confidence it can instill in the minds of the depositors. The bank can never afford to
forget the claims of the depositors. Hence, the bank should always have enough cash
to honour the obligations of the depositors.
4. Borrowings from Other Banks: Under this head, the bank shows those loans it
has taken from other banks. The bank takes loans from other banks, especially the
central bank, in certain extraordinary circumstances.
5. Bills Payable: These include the unpaid bank drafts and telegraphic transfers issued
by the bank. These drafts and telegraphic transfers are paid to the holders thereof by
the bank’s branches, agents and correspondents who are reimbursed by the bank.
6. Acceptances and Endorsements: This item appears as a contra item on both the
sides of the balance sheet. It represents the liability of the bank in respect of bills
accepted or endorsed on behalf of its customers and also letters of credit issued and
guarantees given on their behalf. For rendering this service, a commission is charged
and the customers to whom this service is extended are liable to the bank for full
payment of the bills. Hence, this item is shown on both sides of the balance sheet.
7. Contingent Liabilities: Contingent liabilities comprise of those liabilities which
are not known in advance and are unforeseeable. Every bank makes some provision
for contingent liabilities.
8. Profit and Loss Account: The profit earned by the bank in the course of the year
is shown under this head. Since the profit is payable to the shareholders it represents
a liability on the bank.
9. Bills for Collection: This item also appears on both the sides of the balance sheet.
It consists of drafts and hundies drawn by sellers of goods on their customers and are
sent to the bank for collection, against delivery documents like railway receipt, bill
of lading, etc., attached thereto. All such bills in hand at the date of the balance sheet
are shown on both the sides of the balance sheet because they form an asset of the

33. 14 Banking
bank, since the bank will receive payment in due course, it is also a liability because
the bank will have to account for them to its customers.
Assets
According to Crowther, the assets side of the balance sheet is more complicated and
interesting. Assets are the claims of the bank on others. In the distribution of its assets,
the bank is governed by certain well defined principles. These principles constitute the
principles of the investment policy of the bank or the principles underlying the distribution
of the assets of the bank. The most important guiding principles of the distribution of assets
of the bank are liquidity, profitability and safety or security. In fact, the various items on the
assets side are distributed according to the descending order of liquidity and the ascending
order of profitability.
Now, we have to analyse the various items on the assets side.
1. Cash: Here we can distinguish cash on hand from cash with central bank and other
banks cash on hand refers to cash in the vaults of the bank. It constitutes the most
liquid asset which can be immediately used to meet the obligations of the depositors.
Cash on hand is called the first line of defence to the bank.
In addition to cash on hand, the bank also keeps some money with the central bank
or other commercial banks. This represents the second line of defence to the bank.
2. Money at Call and Short Notice: Money at call and short notice includes loans
to the brokers in the stock market, dealers in the discount market and to other
banks. These loans could be quickly converted into cash and without loss, as and
when the bank requires. At the same time, this item yields income to the bank. The
significance of money at call and short notice is that it is used by the banks to effect
desirable adjustments in the balance sheet. This process is called ‘Window Dressing’.
This item constitutes the ‘third line of defence’ to the bank.
3. Bills Discounted: The commercial banks invest in short term bills consisting of bills
of exchange and treasury bills which are self-liquidating in character. These short
term bills are highly negotiable and they satisfy the twin objectives of liquidity and
profitability. If a commercial bank requires additional funds, it can easily rediscount
the bills in the bill market and it can also rediscount the bills with the central bank.
4. Bills for Collection: As mentioned earlier, this item appears on both sides of the
balance sheet.
5. Investments: This item includes the total amount of the profit yielding assets of
the bank. The bank invests a part of its funds in government and non-government
securities.
6. Loans and Advances: Loans and advances constitute the most profitable asset to
the bank. The very survival of the bank depends upon the extent of income it can
earn by advancing loans. But, this item is the least liquid asset as well. The bank
earns quite a sizeable interest from the loans and advances it gives to the private
individuals and commercial firms.

34. Commercial Banking 15
7. Acceptances and Endorsements: As discussed earlier, this item appears as a
contra item on both sides of the balance sheet.
8. Fixed Assets: Fixed assets include building, furniture and other property owned
by the bank. This item includes the total volume of the movable and immovable
property of the bank. Fixed assets are referred to as ‘dead stocks’. The bank generally
undervalues this item deliberately in the balance sheet. The intention here is to
build up secret reserves which can be used at times of crisis.
Balance sheet of a bank acts as a mirror of its policies, operations and achievements.
The liabilities indicate the sources of its funds; the assets are the various kinds of
debts incurred by a bank to its customers. Thus, the balance sheet is a complete
picture of the size and nature of operations of a bank.
CREDIT CREATION
An important function performed by the commercial banks is the creation of credit. The
process of banking must be considered in terms of monetary flows, that is, continuous
depositing and withdrawal of cash from the bank. It is only this activity which has enabled
the bank to manufacture money. Therefore the banks are not only the purveyors of money
but manufacturers of money.
Basis of Credit Creation
The basis of credit money is the bank deposits. The bank deposits are of two kinds viz.,
(1) Primary deposits, and (2) Derivative deposits.
1. Primary Deposits: Primary deposits arise or formed when cash or cheque is
deposited by customers. When a person deposits money or cheque, the bank will
credit his account. The customer is free to withdraw the amount whenever he wants
by cheques. These deposits are called “primary deposits” or “cash deposits.” It is out
of these primary deposits that the bank makes loans and advances to its customers.
The initiative is taken by the customers themselves. In this case, the role of the bank
is passive. So these deposits are also called “passive deposits.” These deposits merely
convert currency money into deposit money. They do not create money. They do not
make any net addition to the stock of money. In other words, there is no increase in
the supply of money.
2. Derivative Deposits: Bank deposits also arise when a loan is granted or when
a bank discounts a bill or purchase government securities. Deposits which arise
on account of granting loan or purchase of assets by a bank are called “derivative
deposits.” Since the bank play an active role in the creation of such deposits, they are
also known as “active deposits.” When the banker sanctions a loan to a customer,
a deposit account is opened in the name of the customer and the sum is credited to
his account. The bank does not pay him cash. The customer is free to withdraw the
amount whenever he wants by cheques. Thus the banker lends money in the form

35. 16 Banking
of deposit credit. The creation of a derivative deposit does result in a net increase in
the total supply of money in the economy, Hartly Withers says “every loan creates
a deposit.” It may also be said “loans make deposits” or “loans create deposits.” It is
rightly said that “deposits are the children of loans, and credit is the creation of bank
clerk’s pen.”
Granting a loan is not the only method of creating deposit or credit. Deposits
also arise when a bank discounts a bill or purchase government securities. When
the bank buys government securities, it does not pay the purchase price at once in
cash. It simply credits the account of the government with the purchase price. The
government is free to withdraw the amount whenever it wants by cheque. Similarly,
when a bank purchase a bill of exchange or discounts a bill of exchange, the proceeds
of the bill of exchange is credited to the account of the seller and promises to pay the
amount whenever he wants. Thus asset acquired by a bank creates an equivalent bank
deposit. It is perfectly correct to state that “bank loans create deposits.” The derivate
deposits are regarded as bank money or credit. Thus the power of commercial banks
to expand deposits through loans, advances and investments is known as “credit
creation.”
Thus, credit creation implies multiplication of bank deposits. Credit creation may
be defined as “the expansion of bank deposits through the process of more loans and
advances and investments.”
Process of Credit Creation
An important aspect of the credit creating function of the commercial banks is the process
of multiple-expansion of credit. The banking system as a whole can create credit which
is several times more than the original increase in the deposits of a bank. This process is
called the multiple-expansion or multiple-creation of credit. Similarly, if there is withdrawal
from any one bank, it leads to the process of multiple-contraction of credit. The process of
multiple credit-expansion can be illustrated by assuming
(a) The existence of a number of banks, A, B, C etc., each with different sets of
depositors.
(b) Every bank has to keep 10% of cash reserves, according to law, and,
(c) A new deposit of Rs. 1,000 has been made with bank A to start with.
Suppose, a person deposits Rs. 1,000 cash in Bank A. As a result, the deposits of bank
A increase by Rs. 1,000 and cash also increases by Rs. 1,000. The balance sheet of the bank
is as fallows:
Balance Sheet of Bank A
Liabilities Rs. Assets Rs.
New deposit 1,000 New Cash 1,000
Total 1,000 1,000

36. Commercial Banking 17
Under the double entry system, the amount of Rs. 1,000 is shown on both sides.
The deposit of Rs. 1,000 is a liability for the bank and it is also an asset to the bank. Bank A
has to keep only 10% cash reserve, i.e., Rs. 100 against its new deposit and it has a surplus of
Rs. 900 which it can profitably employ in the assets like loans. Suppose bank A gives a loan to
X, who uses the amount to pay off his creditors. After the loan has been made and the amount
so withdrawn by X to pay off his creditors, the balance sheet of bank A will be as follows:
Balance Sheet of Bank A
Liabilities Rs. Assets Rs.
Deposit 1,000 New Cash 100
Loan to X 900
Total 1,000 1,000
Suppose X purchase goods of the value of Rs. 900 from Y and pay cash. Y deposits the
amount with Bank B. The deposits of Bank B now increase by Rs. 900 and its cash also
increases by Rs. 900. After keeping a cash reserve of Rs. 90, Bank B is free to lend the
balance of Rs. 810 to any one. Suppose bank B lends Rs. 810 to Z, who uses the amount to
pay off his creditors. The balance sheet of bank B will be as follows:
Balance Sheet of Bank B
Liabilities Rs. Assets Rs.
Deposit 900 Cash 90
Loan to Z 810
Total 900 900
Suppose Z purchases goods of the value of Rs. 810 from S and pays the amount. S deposits
the amount of Rs. 810 in bank C. Bank C now keeps 10% as reserve (Rs. 81) and lends
Rs. 729 to a merchant. The balance sheet of bank C will be as follows:
Balance Sheet of Bank C
Liabilities Rs. Assets Rs.
Deposit 810 Cash 81
Loan 729
Total 810 810
Thus looking at the banking system as a whole, the position will be as follow:
Name of bank Deposits Cash reserve Loan
Rs. Rs. Rs.
Bank A 1,000 100 900
Bank B 900 90 810
Bank C 810 81 729
Total 2,710 271 2,439

37. 18 Banking
It is clear from the above that out of the initial primary deposit, bank advanced Rs. 900
as a loan. It formed the primary deposit of bank B, which in turn advanced Rs. 810 as loan.
This sum again formed, the primary deposit of bank C, which in turn advanced Rs. 729 as
loan. Thus the inital primary deposit of Rs. 1,000 resulted in bank credit of Rs. 2439 in
three banks. There will be many banks in the country and the above process of credit
expansion will come to an end when no bank has an excess reserve to lend. In the
above example, there will be 10 fold increase in credit because the cash ratio is 10%.
The total volume of credit created in the banking system depends on the cash ratio. If
the cash ratio is 10% there will be 10 fold increase. If it is 20%, there will be 5 fold
increase. When the banking system receives an additional primary deposit, there will be
multiple expansion of credit. When the banking system loses cash, there will be multiple
contraction of credit.
The extent to which the banks can create credit together could be found out with the
help of the credit multiplier formula. The formula is:
Where K is the credit multiplier, and r, the required reserves. If the reserve ratio is 10%
the size of credit multiplier will be:
It means that the banking system can create credit together which is ten times more
than the original increase in the deposits. It should be noted here that the size of credit
multiplier is inversely related to the percentage of cash reserves the banks have to maintain.
If the reserve ratio increases, the size of credit multiplier is reduced and if the reserve ratio
is reduced, the size of credit multiplier will increase.
Leaf and Cannon Criticism
Walter Leaf and Edwin Cannon objected to the theory of credit creation. According to them,
the commercial bank cannot lend anything more than what it receives as cash from deposits.
But the contention of Leaf and Cannon that banks cannot create credit is wrong due to the
following reasons:
(a) A single bank may not be able to create derivative deposits in excess of its cash
reserves. But the banking system as a whole can do what a single bank cannot do.
(b) As Crowther points out that the total net deposits of commercial banks are for in
excess of their cash reserves. It means they can create credit.
Limitation on Credit Creation
The commercial banks do not have unlimited power of credit creation. Their power to
create credit is limited by the following factors:

38. Commercial Banking 19
1. Amount of Cash: The power to create credit depends on the cash received by banks.
If banks receive more cash, they can create more credit. If they receive less cash they
can create less credit. Cash supply is controlled by the central bank of the country.
2. Cash Reserve Ratio: All deposits cannot be used for credit creation. Banks must
keep certain percentage of deposits in cash as reserve. The volume of bank credit
depends also on the cash reserve ratio the banks have to keep. If the cash reserve
ratio is increased, the volume of credit that the banks can create will fall. If the cash
reserve ratio is lowered, the bank credit will increase. The Central Bank has the
power to prescribe and change the cash reserve ratio to be kept by the commercial
banks. Thus the central bank can change the volume of credit by changing the cash
reserve ratio.
3. Banking Habits of the People: The loan advanced to a customer should again come
back into banks as primary deposit. Then only there can be multiple expansion. This
will happen only when the banking habit among the people is well developed. They
should keep their money in the banks as deposits and use cheques for the settlement
of transactions.
4. Nature of Business Conditions in the Economy: Credit creation will depend
upon the nature of business conditions. Credit creation will be large during a
period of prosperity, while it will be smaller during a depression. During periods
of prosperity, there will be more demand for loans and advances for investment
purposes. Many people approach banks for loans and advances. Hence, the volume
of bank credit will be high. During periods of business depression, the amount of
loans and advances will be small because businessmen and industrialists may not
come to borrow. Hence the volume of bank credit will be low.
5. Leakages in Credit-Creation: There may be some leakages in the process of credit
creation. The funds may not flow smoothly from one bank to another. Some people
may keep a portion of their amount as idle cash.
6. Sound Securities: A bank creates credit in the process of acquiring sound and
profitable assets, like bills, and government securities. If people cannot offer sound
securities, a bank cannot create credit. Crowther says “a bank cannot create money
out of thin air. It transmutes other forms of wealth into money.”
7. Liquidity Preference: If people desire to hold more cash, the power of banks to
create credit is reduced.
8. Monetary Policy of the Central Bank: The extent of credit creation will largely
depend upon the monetary policy of the Central Bank of the country. The Central
Bank has the power to influence the volume of money in circulation and through
this it can influence the volume of credit created by the banks. The Central Bank has
also certain powerful weapons, like the bank rate, open market operations with the
help of which it can exercise control on the expansion and contraction of credit by
the commercial bank.

39. 20 Banking
Thus, the ability of the bank to create credit is subject to various limitations.
Still, one should not undermine the importance of the function of credit creation
of the banks. This function has far-reaching effect on the working of the economy,
especially on the business activity. Bank credit is the oil which lubricates the wheels
of the business machine.
UNIT BANKING VS BRANCH BANKING
The banking system in different countries vary substantially from one another. Broadly
speaking, however, there are two important types of banking systems, viz., unit banking and
branch banking.
A. Unit Banking
‘Unit banking’ means a system of banking under which banking services are provided by a
single banking organisation. Such a bank has a single office or place of work. It has its own
governing body or board of directors. It functions independently and is not controlled by any
other individual, firm or body corporate. It also does not control any other bank. Such banks
can become member of the clearing house and also of the Banker’s Association. Unit banking
system originated and grew in the U.S.A. Different unit banks in the U.S.A. are linked with
each other and with other financial centres in the country through “correspondent banks.”
Advantages of Unit Banking
Following are the main advantages of unit banking:
1. Efficient Management: One of the most important advantages of unit banking
system is that it can be managed efficiently because of its size and work. Co-ordination
and control becomes effective. There is no communication gap between the persons
making decisions and those executing such decisions.
2. Better Service: Unit banks can render efficient service to their customers. Their
area of operation being limited, they can concentrate well on that limited area and
provide best possible service. Moreover, they can take care of all banking requirements
of a particular area.
3. Close Customer-banker Relations: Since the area of operation is limited the
customers can have direct contact. Their grievances can be redressed then and
there.
4. No Evil Effects Due to Strikes or Closure: In case there is a strike or closure of
a unit, it does not have much impact on the trade and industry because of its small
size. It does not affect the entire banking system.
5. No Monopolistic Practices: Since the size of the bank and area of its operation are
limited, it is difficult for the bank to adopt monopolistic practices. Moreover, there is free
competition. It will not be possible for the bank to indulge in monopolistic practices.